PREPARING FOR THE LEASE ACCOUNTING RULE CHANGES
PRESENTATION FOR THE DALLAS BAR ASSOCIATION
REAL PROPERTY SECTION
April 8, 2013
E. David Coligado – Munsch Hardt Kopf & Harr, PC
Tom W. Watson – BKD, LLP
PREPARING FOR THE LEASE ACCOUNTING RULE CHANGES
1.
Overview.
A.
B.
2.
Leasing Accounting Rules? But, I’m a Lawyer! Who is affected?
1.
Rules affect all parties that follow “General Accepted Accounting
Principles” (“GAAP”).
2.
In the U.S., GAAP rules are established by the Financial Account
Standards Board (“FASB”) for establishing rules for public and private
companies as well as non-profit organizations, the Governmental
Accounting Standards Boards (“GASB”) for determining the principles for
local and state governments and the Federal Accounting Standards
Advisory Board (“FASAB”) for determining the principles for the federal
government. FASB was created in 1973 to establish and improve the
standards of financial accounting and reporting for nongovernmental
entities in the U.S. The FASB issues pronouncements on accounting and
reporting codified in the Accounting Standards Codification, which are
officially recognized by the SEC and the American Institute of Public
Accountants
3.
Internationally, many countries are moving to the International Financial
Reporting Standards (“IFRS”), which are established by the International
Accounting Standards Board (“IASB”). IASB was founded in 2001 as the
successor to the International Accounting Standards Committee
Why GAAP?
1.
The basic objective of GAAP is to provide a set the rules for financial
reporting that is useful to investors and creditors to make rational
decisions with respect to investments, credit and other financial decisions.
2.
The objective of GAAP is not to affect the underlying economics of the
transaction.
3.
Since 2001, FASB AND IASB have been trying to create joint standards
for showing obligations in financial reporting. The SEC has a stated goal
of moving from US GAAP to the IFRS.
When Will the Lease Accounting Rule Changes Be In Effect?
A.
The FASB/IASB Joint Project to establish unified rules for lease accounting has
been in process for several years. The original exposure draft (the "Exposure
Draft") of the FASB/IASB Joint Project was released August 17, 2010, and was
met with extensive public comment. Both the credit world and real estate world
reacted to the proposed changes.
B.
July 21, 2011 – the Boards agreed to re-expose their revised proposals for a
common leasing standard
Preparing for Lease Accounting Changes
Page 2
3.
C.
As of March 26, 2013, the revised Exposure Draft is scheduled for 2nd Quarter,
2013 (goal of 1st Quarter from last fall has come and gone); followed by a 120
day comment period.
D.
The target is a final standard by late 2013, with an effective date no earlier than
annual reporting periods beginning January 1, 2016.
Why the Rule Changes?
A.
Today, U.S. companies following FASB rules are only required to show leases
meeting certain criteria on their balance sheets. The obligation to make
payments under most non-cancelable leases is not shown as a liability under
current FASB rules.
B.
The official project objective:
“Leasing is an important activity for many entities. Therefore, it is important that
lease accounting provides users of financial statements with a complete and
understandable picture of an entity’s leasing activities. The existing accounting
models for leases require lessees to classify their leases as either capital leases
or operating leases. However, those models have been criticized for failing to
meet the needs of users of financial statements because they do not provide a
faithful representation of leasing transactions. In particular, they omit relevant
information about rights and obligations that meet the definitions of assets and
liabilities in the Boards’ conceptual framework. The models also lead to a lack of
comparability and undue complexity because of the sharp bright-line distinction
between capital leases and operating leases. As a result, many users of financial
statements adjust the amounts presented in the statement of financial position to
reflect the assets and liabilities arising from operating leases.”
C.
D.
The breakdown of the stated objective:
1.
Today’s lease rules allow agreements to be manipulated to garner an
accounting treatment that does not present the economic realities of the
agreement
2.
The need for transparency?
(a)
Reducing “off balance sheet” transactions.
(b)
If financial analysts are including leases in their valuations of
companies, shouldn’t GAAP reflect this?
3.
Leases fall somewhere between a purchase and a service
4.
Globalization - consistency of accounting standards
More from the Joint Project:
1.
The core principle is that lease contracts give rise to assets and liabilities
that should be reflected in the balance sheets of lessees and lessors. As
Preparing for Lease Accounting Changes
Page 3
such, calculated financial ratios (leverage ratios, for example) would be
more complete and comparable.
E.
4.
5.
2.
All lessees would use a single method of accounting for all leases.
Balance sheets of lessees would include both assets representing the
right to use the leased asset and liabilities arising from lease contracts at
the present value of the expected lease payments.
3.
Users of financial statements would have more timely information about
variable features such as renewal options and contingent rentals.
4.
A simplified approach would apply to short-term leases.
5.
The proposal does not change the current definition of a lease contract.
The rules apply to both personal property leases and real estate leases – today,
we are addressing the rules as they apply to real estate leases.
Impact of the Rule Changes
A.
Total U.S. balance sheet effect estimated at over $1.25 trillion.
B.
Increase in corporate balance sheets
C.
Improved EBITDA but lower profits
D.
Potential breach of financial covenants
E.
Increased financial reporting burdens
F.
Possible change in lease terms and lease structure
G.
Effect on decisions to lease v. own
Lease Accounting Rules – Generally – Existing Rules v. Revised Model
A.
Today’s rules
1.
Lease is either an “Operating Lease” or a “Capital Lease’
2.
Operating lease treatment:
3.
(a)
No asset or liability on the financial statements
(b)
Rent is treated as an expense on a straight line basis over the
term of the agreement
(c)
Only reference in the financial statements to an operating lease in
financial reports is by footnote and reflection of the rental
expense.
Capital lease treatment:
Preparing for Lease Accounting Changes
Page 4
4.
(a)
Capital lease is reported as an asset and a liability
(b)
Depreciation and interest
What is a capital lease: Any lease that contains one of the following is a
capital lease:
(a)
The lease includes the transfer of ownership of the leased asset at
the end of the term;
(b)
The lease includes a bargain purchase option for tenant;
(c)
The lease term is equal to 75% or more of estimated economic life
of leased property; or
(d)
The present value of lease payments is at least 90% of the fair
value of the leased asset.
If none of the above, then it is an operating lease.
Classification of the lease is determined at the outset and determined
independently by landlord and tenant.
5.
B.
Leases that are less than 12 months (including all possible renewal) are
treated similar to operating leases
The Proposed Rule Changes: “Right to use” model.
1.
For lessees, all leases become “Capital Leases” – Tenant is “buying” the
use of space.
(a)
(b)
A lease includes:
(i)
Right-of-use assets in a sublease
(ii)
Leases of noncore assets
(iii)
Long-term leases of land.
(iv)
The Boards tentatively decided not to provide a scope
exclusion from the leases standard for assets often treated
as inventory, such as non-depreciating spare parts,
operating materials, and supplies, and that are associated
with the leasing of another underlying asset.
A lease does not include:
(i)
Leases for the right to explore for or use minerals, oil,
natural gas and similar non-regenerative resources
(ii)
Leases of biological assets, including (U.S. generally
accepted accounting principles [GAAP] only) timber
Preparing for Lease Accounting Changes
Page 5
6.
(iii)
(IFRSs only) Leases of service concession arrangements
within the scope of IFRIC 12, Service Concession
Arrangements
(iv)
Short term leases.
Issues Created by the Proposed Rules.
A.
B.
C.
Valuation of the Asset and Lease Term
1.
How to treat renewal options or termination options?
2.
“Significant economic incentive to renew”: This term is not currently
defined and will be highly subjective. Issues like penalties for not
renewing, lessee investments in leasehold improvements, etc. will drive
what renewal periods should be included in the lease term.
Valuation of the Asset and Lease Payments
1.
How to deal with contingent rent (e.g., percentage rent) and uncertain
rent (e.g., rent adjusted by CPI).
2.
How to value purchase options
3.
Adding termination option penalties to lease payments
4.
Adding initial directs costs to the lease (e.g., adding legal expenses).
Valuation of the Asset: Lessor Accounting v. Lessee Accounting
1.
2.
3.
D.
Present value calculation
(a)
Tenant = Tenant’s incremental borrowing rate, unless the rate
being charged by the lessor is not known.
(b)
Landlord = PV implicit in lease rate
Residual values and amortizing the value of the Lease
(a)
For Tenants, recognize in lease payments the amount of RV
expected to be paid based on RV guarantee less the projected fair
value of the asset at the end of the lease term
(b)
Landlords do not recognize RV in their computation of lease
payments
Landlord’s valuation: receivable and residual model or operating lease
model.
Factors requiring reassessment. Leases will need to be reassessed with each
reporting period, so Landlords and Tenants will need to re-evaluate how leases
are reported on a regular basis.
Preparing for Lease Accounting Changes
Page 6
E.
1.
A significant change in factors relevant to determining whether a
significant economic incentive to renew exists
2.
A change in lease payments due to a change in the lease term
3.
A change in the amount of the residual value guarantee expected to be
paid
4.
Changes in an index used to determine lease payments
Separating Components of a Lease
Identifying and separating the lease and non-lease components of a lease (e.g.,
separation of service costs in net v. gross leases).
F.
Goal of rules is to capture the net costs of leases without regard to
operating expenses, taxes, CAM, etc. – such "executory costs" will
now be required to be isolated.
(b)
Some landlords who profit from operating expenses may not like
this additional clarity.
EBITDA Effect
1.
2.
G.
(a)
Front-end loading impact on the reporting of profit and loss for
accelerated leases.
(a)
For Tenants: early years would have reduced net income due to
the added expense of the leased asset but increased EBITDA and
later years would have increased net income but decreased
EBITDA
(b)
For Landlord: greater net income in the early years as compared
to later years if lease qualifies as an accelerated lease.
(c)
Issue: The reporting does not reflect the economic reality.
Employee compensation if tied to EBITDA.
Financial covenants under existing loan documents.
1.
2.
Incurrence of and ratios related to assets and liabilities will change.
(a)
Some covenants restrict capital asset purchases or incurrence of
new debt.
(b)
The number of transactions that will result in new assets and debt
will
Any covenants related to leverage ratios will be impacted by both the
straight-line and accelerated lease models.
Preparing for Lease Accounting Changes
Page 7
H.
I.
J.
K.
7.
3.
Debt service coverage ratios will be impacted by accelerated leases.
4.
Consider revising the definition of GAAP in loan documents (i.e., tie the
definition to GAAP at the date of the agreement.)
5.
Consider a “contract” based audit requirement that would dictate the
manner in which leases are measured
Increased lease accounting burdens for landlords and tenants.
1.
Additional annual and quarterly reporting – the lease term and lease
payment estimates have to be reassessed at each reporting date.
2.
Judgment calls necessary for probability of use and length of leases
Preference for shorter terms? Effects of shorter terms include:
1.
A shorter term will decrease the tenant's reported liabilities.
2.
A shorter term will increase the cost of lease incentives due to the
decreased amortization period and thus may decrease lease incentives.
3.
Short terms may increase the difficulty of landlord financing.
Will companies consider purchasing assets rather than leasing to simplify
accounting?
1.
Leasing will remain a financing tool even with lease accounting rules the Lease Accounting Rules are not changing the essential economics.
2.
Globe St. article in Spring 2012 indicated that a Deloitte study showed
that 42% of real estate executives leaning toward short-term leases and
28% are deciding to purchase rather than lease.
No Grandfathering of Existing Leases – the new Rules are not expected to be
grandfathered.
Preparation for the Lease Accounting Rule Changes?
A.
Tenant actions:
1.
Review existing leases to verify impact on their financial statements
2.
Review existing credit agreements to verify changes in financial
covenants and renegotiate if possible
3.
Review existing leases for problematic lease provision and contact
landlord to revise, if possible.
4.
Review future real estate needs (lease v. own)
5.
Review software needs
Preparing for Lease Accounting Changes
Page 8
6.
B.
Review compensation packages
Landlord actions:
1.
Review existing leases to verify impact on their financial statements
2.
Review existing credit agreements to verify changes in financial
covenants and renegotiate if possible
3.
Review existing leases for problematic lease provision and contact
landlord to revise, if possible.
4.
Review future real estate needs
5.
Review software needs
6.
Review compensation packages
Preparing for Lease Accounting Changes
Page 9
REFERENCES
The following sources provided the guidance for this presentation.
www.fasb.org
Roger D. Aksamit, The Proposed FASB/IASF Rules on Leases-Status, Rules & Overview,
Presentation to HBA Real Estate Section, January 18, 2012.
Marc Betesch, Lou Ferro, FASB Lease Accounting Changes, Commercial Real Estate Leases:
Selected Issues in Drafting and Negotiating in Distressed and Troubled Market, June 11-12,
2012, ST054 ALI-ABA 1327.
Kathleen (Kitty) O'Connell Henry, The "New" Rule 13 – An Overview, September 2010.
Scott Hunsaker, Proposed Major Changes in Lease Accounting, The Real Estate Finance
Journal, Vol. 26, Spring 2011.
Leases Suffer Identity Crisis, CFO Journal, May 22, 2011.
Heads Up, Deloitte & Touche LLP, September 27, 2012, Vol. 19, Issue 24
Mark A. Maiona, The Impact of Changing Accounting Rules on Lease Structures & Audit Rights,
Negotiating Commercial Leases: How Owners and Corporate Occupants Can Avoid Costly
Errors 2011, Practising Law Institute Real Estate Law and Practice Course Handbook Series,
November 17-18, 2011, 594 PLI/Real 797.
Mark A. Maiona, Lease Accounting: A Day At the Track: Combining New Lease Accounting
Standards and a Base Year Lease Audit Make a Winning Ticket Better, Negotiating Commercial
Leases: How Owners and Corporate Occupants Can Avoid Costly Errors 2011, Practising Law
Institute Real Estate Law and Practice Course Handbook Series, November 17-18, 2011, 594
PLI/Real 797.
Marc A. Maiona, New Lease Accounting Standards Are Evolving, Negotiating Commercial
Leases: How Owners and Corporate Occupants Can Avoid Costly Errors 2011, Practising Law
Institute Real Estate Law and Practice Course Handbook Series, November 17-18, 2011, 594
PLI/Real 769.
Stephen F. Olsen, Peter R. McElwain, Thomas F. Kaufman, Accounting Changes for Leases:
How It Will Change Lease Reporting and Leasing, Commercial Real Estate Leases: Selected
Issues in Drafting and Negotiating in Distressed and Troubled Market, June 11-12, 2012, ST054
ALI-ABA 1313.
Martin D. Polevoy, The Proposed Financial Accounting Standards Board Leasing Accounting
Guidelines, Negotiating Real Estate Deals 2012, Practising Law Institute Real Estate Law and
Practice Course Handbook Series, June 5, 2012, 600 PLI/Real 65.
John C. Ramirez , The Property Tax Implications of Lease Accounting GAAP Changes, Journal
of Multistate Taxation and Incentives, February 2012.
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